Fraud and the feeder fund: How Merkin dodged fed. class action

You had to be a sophisticated investor if you wanted to give J. Ezra Merkin your money. The hedge fund director made that clear in the offering documents for three of his funds: investors had to entrust considerable assets to him (at least $5 million for individuals and $25 million for businesses); had to conduct their own due diligence before deciding to invest; and had to accept the risk that Merkin’s funds might lose their money. Unsaid, but well-understood by many of the investors in Merkin’s Ascot fund (at least according to Merkin lawyer Andrew Levander of Dechert), was that Merkin would be feeding investors’ money to Bernard Madoff.

Merkin earned between 1 and 5 percent fees on the hundreds of millions of dollars he funneled to Madoff beginning in the early 1990s. At the same time, his own Madoff investment blossomed to more than $100 million. When Madoff’s Ponzi scheme was exposed in December 2008, Merkin was as stunned as his hedge fund clients, according to his lawyers. Merkin also claimed that he and his family were among Madoff’s biggest victims, with nine-figure paper losses.

Many doubted that depictions of events, including the New York attorney general, who filed a state-law fraud action against Merkin; real estate developer and Merkin investor Morton Zuckerman, who brought in Susman Godfrey for a New York state supreme court suit; and investors in Merkin’s Ascot, Gabriel, and Arial funds, whose cases were consolidated in June 2009 in a Manhattan federal court securities class action. The hedge fund investors, represented by lead counsel from Abbey Spanier Rodd Abrams & Paradis and Wolf Haldenstein Adler Freeman & Herz, alleged that Merkin had misrepresented the operation of his funds in offering documents that implied Merkin himself — and not Bernie Madoff — would be making investment decisions. They also asserted that Merkin ignored warning signs.

In an August 2010 motion to dismiss, Dechert focused on the “explicit disclosures” in the fund offering materials, which, according to Dechert, specifically granted Merkin the right to delegate investment decisions to outside money managers. “The offering memoranda disclosed not only the fact that investment discretion would be delegated to other money managers, but also the heightened risks associated with delegating assets,” the brief said. The funds weren’t required to disclose that the outside money manager was Madoff, the brief said, but the Ascot documentation did just that, twice identifying Madoff as the prime broker and custodian of the fund. Moreover, Merkin’s own enormous losses in Madoff’s Ponzi scheme were proof that he wasn’t acting with the requisite intent to deceive his investors.

Judge Deborah Batts, who’s overseeing the federal class action, agreed. In a 40-page ruling disclosed Monday, the judge concluded that the plaintiffs had plucked particular statements out of offering documents while ignoring the overall context of the hedge funds’ investment disclosures. “Plaintiffs cannot be permitted to ‘cherry pick’ language from the offering memoranda, and then ignore explicit cautionary language, which warned plaintiffs that third-party managers would have custody over the funds’ assets,” she wrote.

Nor was there evidence that Merkin knew or should have known Madoff was a Ponzi schemer, the judge found; unlike the Fairfield Greenwich defendants in a ruling by her Manhattan federal court colleague Victor Marrero, Judge Batts said, Merkin didn’t evidence serious doubts about Madoff until it was too late.

In what may turn out to be the most controversial parts of Batts’s ruling, the judge dismissed the investors’ state and common law claims, finding that they’re precluded by the federal law pre-empting suits involving financial instruments covered by the Securities Act of 1933 and the Exchange Act of 1934 and New York State’s Martin Act, which reserves state-law fraud cases for the AG.

That holding, according to Morton Zuckerman’s lead counsel, rules directly contrary to prior rulings by state supreme court judge Richard Lowe III in the Zuckerman and state AG cases against Merkin. In fact, said Harry Susman of Susman Godfrey, Judge Batts’s dismissal is “crazy. She’s a federal judge and I don’t want to second-guess her, but all you can do is shake your head.” In Zuckerman’s case, Susman said, Judge Lowe recently re-instated state law securities fraud claims after a state appellate court found they’re not precluded by the Martin Act. (Susman did concede that unlike investors in the federal class action, Zuckerman was able to point to specific assurances he received from Merkin about how his investment would be handled.)

Presumably, the investors in the dismissed federal class action could still see some recovery from the AG’s suit against Merkin, which is headed for a summary judgment ruling on liability. Lawyers at Abbey Spanier and Wolf Haldenstein declined my requests for comment.

But Merkin counsel Andy Levander of Dechert said Judge Batts’s opinion is vindication for Merkin. “It’s what we’ve said all along,” Levander told me. “The facts show the Mr. Merkin was not a crook, not a fraudster. He did a good job but he missed this.” Levander declined to comment on whether Judge Batts’s opinion will have sway in the AG case, but said, “It’s a good first step.”